MI359: The Intelligent Investor w/ Shawn O'Malley

0:00You're listening to TIP. And we all know this intuitively too, because of 2021's stock market, and how recent of an illustration of what mania and markets can look like, right? We saw this with GameStop, AMC, Tesla, crypto, altcoins, and SPACs. None of this makes a particularly compelling case for the efficient markets hypothesis being believable, right? And being an intelligent investor is to recognize when markets have gotten out of whack and to have discipline to swallow your FOMO and to spring into action when financial asset prices are excessively discounted in a bear market on the flip side of that.

0:37It's one of those things that sounds tantalizingly easy. But when you look at yourself in the mirror and ask, how did I respond in 2021? When everyone was getting rich, trading on stock tips from neighbors, and you saw people getting rich on Dogecoin, did you really have the restraint to sidestep that speculation?

1:00Hey, guys. In this week's episode, I had the pleasure of sitting down and talking with Sean O'Malley, chief editor of our newsletter, We Study Markets, to discuss what his main takeaways were from doing a deep dive into The Intelligent Investor by Benjamin Graham. Buffett called The Intelligent Investor the most important book on investing ever written and said outside of his own father, Ben Graham was the most influential person on his own life. You'll learn what the main principles of the book that stood out to Sean were, what an intelligent investor does that average investors don't do, why common sense is more important than a high IQ in investing, how to apply the idea of margin of safety, how to do an intrinsic value calculation, how to benefit from the mood swings of Mr.

1:42Market, plus so much more. Sean does a great job in distilling the most useful concepts in the intelligent investor and how to apply them in today's market. Without further delay, let's dive into today's episode. with Sean O'Malley and the main lessons you need to know about from the intelligent investor.

2:03Celebrating 10 years, you are listening to Millennial Investing by the Investors Podcast Network. Since 2014, we interviewed successful entrepreneurs, business leaders, and investors to help educate and inspire the millennial generation. Now for your host, Patrick Donnelly.

2:30Hey, everybody. Welcome to the Millennial Investing Podcast. I'm your host today, Patrick Donnelly. And joining me in the studio is my friend and colleague, Sean O'Malley. Sean, welcome to the show. Hey, Patrick. Thanks for having me back on. I'm happy to have you back on. This is going to be our second series discussing great value investing books. Last week, we discussed the essays of Warren Buffett, written by Larry Cunningham. Today, we're going to get into what's arguably the seminal most important value investing book, which is The Intelligent Investor by Ben Graham. Graham is better known for his...

3:04Well, he's known for a lot of things, but his protege, Warren Buffett, called him the second most influential person in his life, aside from his own father, which is pretty high praise. I think Buffett read The Intelligent investor at 19. And at that point said it was the most important investing book he'd ever read and still is today. So we're going to dive into it. The book was first written in 1949, and Graham updated it throughout his life, did some revisions. Graham died in 1976. And about 21 years after that, Jason Zweig of the Wall Street Journal, who is one of the best financial writers on the planet today, as far as I'm concerned, did a commentary after each chapter to update it for the 21st century.

3:48So I just wanted to get into what principles stood out for you as you read the book. And then in what ways can we translate the book into today's 2024 world? It's definitely a book most people will be familiar with, even if they've never sat down to read it start to finish. It's kind of like a value investor's Bible. It's definitely not a short read. And I know that my first time going through it, to your point, I was itching for another revised edition because as you said, it's been several decades since we had an updated version of it by Jason Zweig. And Warren Buffett actually wrote a preface for The Intelligent Investor where he argues that years on from Graham's first writing, he has yet to find anyone with more enduring principles for investors.

4:35And that's because the book is just practical. It's an extremely sober assessment of what it means to be an investor, what we should expect from our efforts in investing and the pitfalls that many fall into. Since Graham first wrote the book, a ton of brilliant investors have taken a stab, distilling his ideas into more digestible formats. But there's something special about the original work and seeing it for yourself. I compare it to seeing pictures of some famous masterpiece or artwork for years. and then the difference in actually finally venturing to see it for yourself in person in a museum or a gallery.

5:16It's just a different thing. So much of the common sense you've probably heard in life about finance and investing stems pretty directly from Graham's original insights about investing in this book. But it's in a more raw form since the ideas to him were newer. And there's been a lot of time to distill those ideas into more digestible formats. I think it's safe to say the book doesn't really flow as smoothly as some hit book you might find on investing and finance at the bookstore today. But whether you've actually read the book offers a pretty good litmus test about how serious of an investor you are.

5:53Someone who's read The Intelligent Investor cover to cover, when I meet people like that, it just signals something about their willingness and interest to dive into the foundations of investing. As you said in the last edition of the book, which is already more than 20 years old, Jason Zweig tries to modernize Graham's original writings and carry his legacy into the 21st century. And in his first comments in the revised 2003 edition, Zweig argues that money managers before Graham were like this medieval guild guided by mostly superstition, guesswork, and rituals. But Graham's lifetime of work helped transform the investment management industry into a serious, more respected profession.

6:36And after the speculative mania of the 1920s, and then the Great Depression, stock investing fell out of favor in a way that I think would be unrecognizable now to most people. Today, sort of people just assume that they can plow money into the 401k, into stock index funds, and they're going to reliably get this 8 % to 10 % annual return. And nothing about that is really that controversial. But to kind of step back in time for years after the Great Depression, there was a stigma around stock investing. And it was very mainstream to see stock investing as hugely risky and very speculative after the losses that so famously happened in 1929 and in that stock market crash.

7:17It was almost seen as kind of a gentlemanly thing. No respectable gentleman would be caught dead rolling the dice on stocks. It would be like being caught in the casino. There was this popular bias against stock investing, in part because there weren't established ways to value a company's stock. So of course, your average person thought stock investing was gambling. If you couldn't imagine a way to determine whether you were paying fair value for a stock. And I think that's partly why this book was so impactful. It creates this blueprint for intuitively and logically thinking about valuing stocks and what it even means to be a shareholder in a company.

7:55What's also special about Graham is that he's such a gifted thinker in so many ways beyond investing. He's very multidisciplinary, as Charlie Munger would say, which I think explains how he brought order to this industry that was really in disarray after the Great Depression and during World War II. Graham attended Columbia University on scholarship. And I mean, this is just really astonishing. And it stood out to me when I first for the book. By his senior year at 20 years old, three different departments, English, mathematics, and philosophy had asked him to join as a PhD faculty member after graduation.

8:33I don't know about you, but when I wrapped up college, I definitely did not have multiple professors from different departments begging me to stay around. No one has that kind of impact. So, he's just a very special thinker across a range of disciplines. And that logic carries with him when he starts his career on Wall Street. But that logic, I don't think is necessarily born out of a high IQ. Life experience for him played a major role in shaping how he thought about investing. Graham was born into this wealthy family that lost everything in the early 20th century when his father died. We're talking about maids and servants on Fifth Avenue, kind of wealthy, only to completely 180 and become dirt poor.

9:16And that fixation for him on never wanting to lose everything again really stuck with him. So much of Graham's writings are focused on being as conservative as possible and ensuring that you have no illusions about investing that could cause you to lose everything as his family once did. For him to have survived the Great Depression and World War II as an investor and continue to build his wealth and beat the market averages over that period is a testament to how enduring his approaches through really any headwind imaginable. I don't think I could imagine bigger headwinds than those two events, essentially back to back.

9:54And for example, when we look at 1949, the Dow Jones was one third lower than its level in 1939. So if you think about that in today's context, that would be like the S &P 500 sitting at a fraction of its 2004 level, which I think is just extremely difficult for people to even imagine and realize that that is actually precedented in stock market history. To watch the stock market, not just be flat over several decades, but to actually decline. And yet Graham's pragmatic advice is pretty familiar to us today still. He writes it by simply dollar cost averaging with a small fraction of your income each month into these large established businesses for 20 years, starting in 1929, you would have earned an 8 % compounded annual return over that period, despite the broader index being down 33 % from the 1929 peak.

10:48The takeaway being that with this simple approach of dollar cost averaging, the market averages following don't have to be a death sentence for the returns that you earn. And when I think about translating the book to today, it's mostly about putting his lessons in a context that resonate with the world we've grown up with. And world wars and great depressions can seem very distant, which can make his writings feel less relevant. But in the grand scheme of history, in the 80 years since World War II, things have been very quiet and tame. Yet that almost certainly will not be the case forever, right?

11:25We saw that with the COVID-19 pandemic in 2020. I think that was kind of this first wake-up call for people that the society around us is not as stable as we might think it is or or want it to be. And that unimaginable shocks can still emerge to disrupt our lives. So some people will read Graham's book as overly cautious. But the point is really that if you want to be an intelligent investor, who can survive any period in markets, as he did, you should study Grant because of, you know, instead of just speculating that the future will offer a smooth ride with excellent returns, similar to or better than the past.

12:02By being conservative as he was, we can prepare ourselves for any different environment. One of the things that really surprised me as I was reviewing the book, I've got my original copy here that I bought in 2008 during the great financial crisis that I still have, and it's a Bible of sorts. But the story that you were telling about his family being super wealthy, his father died, his mother had a boarding room house that she did just to kind of keep the money and coming in and a little food on the table. But she started trading stocks on margin and was completely wiped out in the 1907 financial crisis that happened that year.

12:38So it's really shocking to me that he ended up in a career on Wall Street after those kinds of experiences of getting just blown out, really horrible traumatic experiences. I would have been surprised or not surprised had he just pursued a career in academia. I mean, he clearly had a path and he did to some degree, but like just a full-fledged ignore Wall Street altogether. So I just wanted to touch on the title of the book, The Intelligent Investor. What does that mean to you? How would you define what is an intelligent investor? I'd say it has almost nothing to do with being intelligent in an academic or high IQ way.

13:15That's something Graham actually tells us pretty explicitly, and Buffett builds on it later and validates this idea as well. People with a strong ability to defer gratification, as in having patience and discipline, are far likelier to succeed in investing than a highly emotional but ultra-intelligent person. You can imagine this genius type who just has no control over their emotional impulses. And it's not hard to imagine that they're not going to succeed despite being so brilliantly intelligent. And to quote Graham directly here, he says, this type of investment intelligence is a trait more of the character than of the brain, meaning the behavioral side of investing is as important or more than your ability to solve problems, which is the classic definition of brain intelligence.

14:05I love Jason Zweig's commentary for this section. He cites the infamous story of the hedge fund long-term capital management, which employed this huge team of mathematicians, physicists, and Nobel Prize winners. And despite all that brainpower, they suffered a massive$2 billion blow up in 1998 that disrupted the entire financial system. So being too book smart and investing without any grounding in the real world can work against you. And another great example of that is with Isaac Newton and the South Sea bubble, where he's quoted as saying he could calculate the motion of the heavenly bodies, but not the madness of the people.

14:44This is a guy who invented calculus, invented. And he fell victim to the mania of financial bubbles and just the collective excitement that was in the air. And after he actually initially made a profit, he bought in again at the market top, essentially lost everything or everything that he had invested. And I just think it's such a powerful example for us. Because if Isaac Newton can fail to remain logical when managing his own money, I think it's a risk that can impact anyone. And it's not to say that having a low IQ is better, but more that a stratospheric IQ without the right emotional prerequisites does not necessarily give you the advantages that people think it does.

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18:08To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks. And for a limited time, you can use code stocks15 for a 15 % discount at checkout. All right, back to the show. I think it's funny, the Isaac Newton story, like he said, he invented calculus. He ended up losing, I think the equivalent of$3 million in the South Sea bubble. And after that, he would not let people even mention the South Sea company at all in his presence. So it's just funny how investing attracts so much intellectualization, and yet that can be completely counterproductive.

18:50It's not like low IQ people are going to work on Wall Street, but at the same time, there's all these complex formulas that these PhDs have, and yet you still have these blow up crises like 2008. I wanted to hear a little bit about your thoughts on just how common sense is so vital and is an advantage in investing. This is something Buffett has long talked about, but one obvious area where intellectualism has gone too far in finances is with the efficient markets hypothesis. It's the belief that markets perfectly reflect all information in stock prices and therefore perfectly discount each stock on level ground.

19:28Even back in Graham's day, he acknowledged and saw that this was mostly true. Most of the time, stocks do a pretty good job of responding to changes in the real world. If Walmart reports a blowout quarter, it's probably going to rise. If Meta reveals that people are using its social networks less, its stock is probably going to fall. But there's a big difference in prices always and mostly being accurate. It's like saying most of the time, I remember to drive on the right side of the road. That's a pretty consequential distinction. And that differential between always and mostly and investing has enabled history's best investors to earn the kind of mind-numbing returns that you see across their lifetimes.

20:10And again, I think the academics are too smart for their own good here. The typical response would be to say, you know, well, statistical outliers are to be expected, and that the Buffetts or Grams of the world are natural occurrences that we can, you know, mathematically expect. With the implication being that they're just two random statistical outliers. I think we can reject that with a little bit of common sense, right? You know, Grams framework for common since investing has worked since the Great Depression. And his best student, Warren Buffett, embraced those teachings and turned them into an even more impressive career, spending almost 70 years.

20:44Is that really just random? If it is, and Graham has no secret sauce, what are the odds that another one of these one in a million statistical outliers and investment returns would be a direct disciple of his? I think it just doesn't pass the smell tests. In theory, based on randomly occurring standard deviations from the average, somebody is bound to have market beating investment returns. And that would be more due to luck than their philosophy. And if that's the case, obviously, there'd be no substance that we could learn from them by trying to study them. But again, what are the odds that one investor with three or four standard deviation returns from the mean would produce another investor who is even more of a statistical outlier.

21:27And the main reason for that is because Graham isn't giving an exact formula to replicate and expect the same success. Being an intelligent investor is more of a way of life than a formula, in my opinion. It's a framework for instilling discipline into a medium where the pursuit of profit is blinding for the vast majority of people. So becoming an intelligent investor is in part recognizing that markets aren't perfectly intelligent 100 % of the time. And everyone likes to reference the 2000 tech bubble to show this, which we talked about in our episode about the essays of Warren Buffett. But it was such a crazy time that I do think it is worth revisiting.

22:07And Cisco at the time was supposed to be this big beneficiary of the internet revolution. And it has been. But the stock has never recovered from its peak in 2000. And it's the same with microstrategy. To the intelligent investor, it's pretty clear that this was a classic case of stock prices just getting way ahead of any plausible business outlook that could be expected. And Cisco by no means is the most egregious example from that period either. Most of those 2000 era tech bubble darlings faded into oblivion and just got completely wiped out. And some of them lived on and traded a fraction of their peaks and are kind of haunted by those crazy past valuations of just 24 years ago.

22:49And we all know this intuitively too, because of 2021's stock market and how recent of an illustration of what mania and markets can look like, right? We saw this with GameStop, AMC, Tesla, crypto, altcoins, and SPACs. None of this makes a particularly compelling case for the efficient markets hypothesis being believable, right? And being an intelligent investor is to recognize when markets have gotten out of whack and to have the discipline to swallow your FOMO and to spring into action when financial asset prices are excessively discounted in a bear market on the flip side of that. It's one of those things that sounds tantalizingly easy.

23:28But when you look at yourself in the mirror and ask, how did I respond in 2021? When everyone was getting rich, trading on stock tips from neighbors, and you saw people getting rich on Dogecoin, did you really have the restraint to sidestep that speculation? You're probably thinking, well, yes, of course, I'm a disciplined and rational person. But again, if you answer that honestly, most of us, I think in one way or another fell victim to speculation and failed to behave like an intelligent investor at some point in 2021, which is okay. But that honesty with yourself is the key part. If you can't be honest that you fell into those speculations, then I don't think there's really any hope that you can avoid those illusions in the future.

24:13And you're probably going to be destined to be an average investor as opposed to being an intelligent investor. I wanted to just take a moment to just revisit the idea of updating and translating Graham's writings dating back to before 1950 for us to today. I just wanted to hear your thoughts on what stands out as items or maybe chapters that need revision or more context. One of the biggest for me is Graham's focus on dividends. When you look at some of his rules of thumb for filtering down intelligent investments. Much of that focus relates to dividends, either the dividend yields available and how they compare to available bond yields, or investing only in companies with proven track records of stability, measured by their history of steady growth of their dividend payments over at least two decades.

25:03This largely has to do with the reality that cash dividends were seen very differently back then. The best companies were those who could afford to pay massive and growing dividends because that was a sign of their profitability. And weaker businesses were thought to be those that couldn't afford to pay dividends at all. Today, it kind of goes without saying that people see that differently, right? If a business is paying out large and growing dividends, people sort of think that they either have limited meaningful channels to continue growing their business through, or they're forsaking that growth to pay dividends.

25:35And either way is going to be problematic. If a company today is a leader in its industry and can reinvest its profits to confidently earn, say, a 10 or 20 % return on that capital, that is a far better use for the money than paying out that cash instead to investors who are going to have to allocate it somewhere else and probably earn a lower return to say nothing of the double taxation that occurs when dividends are paid out. In the decades since, for better or worse, a lack of dividends has come to mean that a company has compelling future business prospects it can be reinvesting into and channeling cash into, as opposed to paying out the rewards to shareholders.